The monetary transmission mechanism in Uganda

There are strong a priori reasons to believe that monetary transmission may be weaker and less reliable in low- than in high-income countries. This is as true in Uganda as it is elsewhere. While its floating exchange rate gives the Bank of Uganda monetary autonomy, the country’s limited degree of integration with world financial markets limits the strength of the exchange rate channel of monetary transmission. The country lacks large and liquid secondary markets for debt instruments, and its stock market is both extremely small and very illiquid. This means that monetary policy effects on aggregate demand would tend to operate primarily through the bank lending channel. Yet the formal banking sector is small, and doesn’t intermediate for a large share of the economy. Moreover, there is evidence both that the costs of financial intermediation are high and that the banking system may not be very competitive. The presence of all of these factors should tend to weaken the process of monetary transmission in Uganda.

This paper examines what the empirical evidence has to say about the strength of monetary transmission in Uganda, using the vector autoregression (VAR) methods that have been applied broadly to investigate this issue in many countries, including high-, middle-, and low-income ones. I estimate a monthly VAR with data from December 2001 to June 2011, when the Bank of Uganda switched its monetary policy regime from one that used the monetary base as its operating instrument to one that relies on a policy interest rate. Applying a variety of methods to identify exogenous movements in the monetary base in the data, I find consistently that positive shocks to the base result in statistically significant effects on the exchange rate, bank lending rate and the price level in the direction predicted by theory, a set of findings that is unusual among low-income countries. However, the effects on the price level are quantitatively small, and while the impacts on my monthly proxy for real economic activity are in the theoretically-expected direction on impact, this does not hold true over a longer horizon and such effects are never statistically significant. In other words, the empirical tests do not yield evidence of strong impacts of monetary policy on aggregate demand in Uganda. The most likely explanation is that the formal financial system remains rather small relative to the size of the economy.

This situation appears to be evolving rapidly, however. Uganda is becoming increasingly more integrated with international financial markets, a development that will strengthen the exchange rate channel of monetary transmission, and the recent change in the monetary policy regime can be expected to strengthen the links between monetary policy actions and bank lending rates, as well as between bank lending rates and aggregate demand. Though these developments will strengthen monetary transmission in Uganda, their scope for doing so will remain constrained in the short run by the size of the formal financial sector.